Cheapest-to-deliver: Difference between revisions

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 As such, the market is generally opaque and, “sticky”: debt instruments are illiquid in a way equities, which generally have none of those limitations, are not. By the same token some debt instruments — publicly quoted senior bonds — are a lot more liquid and transparent than others.
-You might be able to buy a put on quoted bond at a reasonable price, but good luck with a privately negotiated term loan.
+You might be able to buy a put on quoted bond at a reasonable price, but good luck with a private term loan.
+Since, except in a [[tail event|disaster scenario]], debt repayment values are predictable in date and amount — unlike say equities or commodities — as long as your borrower doesnʼt blow up, you will eventually get your money back, so it usually doesnʼt matter much that you canʼt — but when it ''does'' matter, it matters ''a lot''.
+When you buy debt repayment protection you are necessarily hedging against a crash — not just a change in value.<ref>this is why, despite referencing an instrument further down the capital structure, [[equity derivatives]] are curiously '' less '' concerned with default than are [[credit derivatives]]. </ref>
+The [[credit default swap]] emerged as a neat way to manage that risk. To cover against losses on an illiquid private bilateral loan, you could buy a [[credit derivative]] referencing a publicly quoted debt  instrument (whose failure, being public you did not need to prove) and your counterparty must pay you a sum calculated on the estimated market price of a range of observable liquid instruments. This is to be sure, only a proxy for your actual loss, but a lot better than nothing.
+Now. A [[CDS]] is only better than a bond put if the instrument you hold is not an observable, liquid instrument that you can freely put to someone. If it is, just buy a put! But if it isnʼt, expect some wangling about how to ''value'' it. It is one thing setting the ''trigger'' for the default, another to chose the instrument by reference to which you calculate its magnitude.
+Hence the titular “cheapest to deliver”: where a range of deliverable obligations are specified, the calculation agent — usually the Buyer — gas discretion as to which she will choose. ''She will choose the cheapest''
-Since, except in a [[tail event|disaster scenario]], debt repayment values are predictable in date and amount (unlike equities or commodities) as long as your borrower doesnʼt blow up you will eventually get your money back, it usually doesnʼt matter much — but when it ''does'' matter, it matters ''a lot''. You are hedging against a crash, not a basic variation in value.<ref>this is why, despite dealing with an instrument further down the capital structure [[equity derivatives]] are curiously '' less '' concerned with default than are [[credit derivatives]]. </ref>
-The [[credit default swap]] emerged as a neat way to manage that risk. To cover against losses on my private bilateral loan I could buy a credit derivative which would pay out if the borrower defaulted on its quoted debt (a public event I donʼt need to prove) and my counterparty must pay me a sum calculated on the estimated market price of a range of observable liquid instruments. A proxy for my loss: not perfect, but good enough
 ====Trades are zero-sum games====
 Where a contract can be fully understood in monetary terms, expect the parties to do the utter bare minimum to discharge it.